A Most Savage Credit Crunch

While the Fed hiked its rate by a paltry 25 basis points, the bond market
used a hammer, raising 10-year Treasury yields by 100 basis points within just
two weeks - that is, by nearly a full percentage point.

If the Fed truly and urgently wanted credit restraint, the action in the bond
market should have pleased them. We suspect the abrupt surge of long-term rates
has shocked them, because the resulting higher mortgage rates have effectually
choked the mortgage refinancing bubble, presenting policymakers in the Fed
with far more credit tightening than they really want.

All their hawkish talk, we presume, was intended rather to calm the inflation
fears in the market by emphasizing the Fed's anti-inflation vigilance, thereby
hopefully moderating the rise in longer-term market rates. In any case, the
talk about a rate hike was much ado about nothing.

In his London speech, Greenspan cited that "the rise in rates... has induced
a dramatic fall in mortgage refinancing." According to the Mortgage Bankers
Association (MBA), mortgage-financing activity in the United States in the
week ending June 4 was down 68% compared to a year ago. The MBA's Refinancing
Index had even plunged by 85% year over year.

Yet the impact of the higher interest rates seems to have been cushioned by
a surge in the demand for adjustable rate mortgages (ARMs).

What exactly could or would the Fed accomplish with a quarter-point rate hike?
What would that do to the economy and the financial system? In short, it would
not be likely to change much, if anything at all. Even the carry trade would
still be profitable at this higher rate.

In fact, the existing short-term rate of 1% is ridiculously low for a supposedly
booming economy to begin with. But most of the profits derived from this record-low
rate go to the financial system, funding its assets in large part by this rate.
Manifestly, Wall Street firms, banks and hedge funds could easily cope with
a slightly higher federal funds rate. For consumers and non-financial firms,
the Fed's 1% rate is pure theory - except for savers.

What truly matters, in particular for financial institutions heavily engaged
in carry trade, are changes in the long-term rate, because they directly hit
their capital, and that, of course, with high leverage. The rise by 100 basis
points reduces the value of 10-year bonds by almost 10%. Given that the carry
trade with bonds is generally leveraged at 20:1, or 5% equity, this loss of
value in the bond holdings actually wipes out more than the invested capital.

In hindsight, it seems reasonable to say that by maintaining the consumer
borrowing and spending binge in the face of plummeting income growth, the mortgage-
refinancing bubble has been the U.S. economy's lifeline. Consumer spending
posted a new historical record in the sense that it outpaced total economic
growth. With an overall increase of $625.8 billion, for the first time in history
it exceeded the simultaneous GDP growth, up $581 billion. The consumer achieved
this with a debt surge of $1,678.8 billion.

But as explained, this lifeline has been badly damaged. There is no spectacular
collapse like that in the stock market of 2000-01. Yet a drastically deflating
mortgage- refinancing bubble is sure to have a much greater effect on the economy.
What is unfolding there is not just gradual credit restraint. It is a most
savage credit crunch with obvious, most dismal consequences for consumer spending
and the economy.

All the more, it stuns us how little attention this fact is finding. Just
weeks ago, the question of a possible quarter-point rate hike by the Fed provoked
an agitated public discussion. Now there appears to be a savage credit crunch
in the offing, and nobody seems to even notice.

In our view, the fate of the mortgage refinancing bubble and its further impact
on the economy is presently the single-most important issue facing the U.S.
economy. All other major GDP components are much too weak to take over as the
new locomotive. Consider that nonresidential business investment contributed
just 0.30 percentage points to real GDP growth in the first quarter of 2004.
Consumer spending remains so predominant that any weakness on its part would
instead pull down the other components.

Of the numerous economic data that America's statisticians constantly publish,
a single forthcoming number appears absolutely decisive under these circumstances.
That is real consumer expenditures in May, in the Personal Income and Outlays
report published June 28 (just after this letter has gone to the printer).

As earlier elucidated, the numbers for the first four months of 2004 have
been unusually weak. Overall growth was $61.5 billion, or $184.5 billion at
annual rate. This compares with an annualized increase in the fourth quarter
of 2003 by $388.4 billion and an increase over the whole year by $297.7 billion.
To speak of any traction in this economy is absurd. With the mortgage-refinancing
bubble seriously jeopardized, more weakness is the only thing we can imagine
for consumer spending.

The other bubble that gives us the greatest headache is the highly leveraged
carry trade in longer-term bonds. We ask ourselves how this monstrous bubble,
having certainly run into several trillion dollars, can ever be unwound without
pushing market interest rates substantially upward.

Well, prices of longer-term bonds crashed in April-May. For 10-year bonds,
the loss was close to 10%. For the time being, U.S. bonds have stabilized at
their lowered level, as unwinding - in other words, selling - has drastically
abated or stopped. But it is a deceptive stability. Such a huge bubble that
has been built up over two or three years is not liquidated within weeks. For
sure, the bulk of the carry trade still hangs over the markets.

The decisive point to see about the carry trade of bonds from a macro perspective
is that huge purchases of bonds with borrowed money essentially result in artificially
low longer-term interest rates. Normally, such purchases ought to come exclusively
from current savings.

While the U.S. economy has near-zero domestic savings, it possesses a financial
system that, thanks to its central bank, knows no limit in credit and debt
creation. It is a financial system of virtually unlimited "elasticity," one
might say.

However, this extraordinary financial elasticity works overwhelmingly in two
directions: personal consumption and financial speculation. During the 13 quarters
from end 2000 to the first quarter of 2004, private household debt has soared
by $2.52 trillion, or 36%, and financial sector debt by $2.9 trillion, or 35%.
Jumping from $578.1 billion in 1980 to $11,280.6 billion in the first quarter
of 2004, the debt of the financial sector in the United States has skyrocketed
from 21% of GDP to 98.4%.

Mr. Greenspan keeps hailing this extraordinary ability of the U.S. financial
system for expansion as a sign of superior efficiency. We increasingly wonder
about its elasticity in the opposite direction, that is, when it comes to unwinding
existing bubbles, regarding the immediate surge of long-term interest rates
only as a first taste of things to come.

Building the huge carry-trade bubble of bonds during the past few years has
been fun because the yield spread and rising bond prices lured ready buyers
en masse. It was a pleasure for sellers and buyers. But we wonder from where
the huge buying of bonds will come when selling pressure from the unwinding
of this bubble will develop in earnest.

Imagine, America's whole financial system has trillions of dollars in the
same boat. But what can possibly trigger heavy selling of this kind? For sure,
the Fed is desperate not to upset this boat with the major rate hikes that
could do so. If it feels compelled to move in order to satisfy bond vigilantes,
it will do no more than minimal, so to speak, rather symbolical rate hikes.

Considering the huge amounts involved in the U.S. carry trade, we think that
this bubble has, actually, become far too big to allow for orderly unwinding,
by which we mean unwinding with moderate interest effects. Under the conditions
created by the Fed, it was easy to create virtually unlimited leveraged buying
of bonds on the way up. But there are few willing buyers on the way down.

But to be sure, it is impossible to recreate these conditions. First of all,
rate cutting by the Fed has spent its power; second, there will be upward pressure
on interest rates from new credit demand; and third, being outrageously overloaded
with highly leveraged bond holdings, the financial system will be a very reluctant
buyer of new bonds.

All in all, the asset bubbles have over time become far too big to allow for
orderly unwinding. With the highly leveraged carry trade in bonds alone running
into several trillions of dollars, one has to wonder where and who the necessary
potential buyers for these trillions are that would make such extensive deleveraging
possible. The fact to see is that the Greenspan Fed has lured the U.S. financial
system into a horrible liquidity trap.

Dr. Kurt Richebacher is the editor of The Richebacher Letter.
Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job
of central bankers is to prove Kurt Richebächer wrong." A regular contributor
to The Wall Street Journal, Strategic Investment and several other respected
financial publications, Dr. Richebächer's insightful analysis stems from
the Austrian School of economics. France's Le Figaro magazine has done a feature
story on him as "the man who predicted the Asian crisis."